Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

CONSUMER BEHAVIOUR

PREFERENCES

Customers have tastes or preferences that guide them when choosing between different goods.

Consumption bundle: set of goods or services a consumer may choose to consume.

> (𝑋! , 𝑋" ) is a bundle: any combination of a certain number of 𝑋! and 𝑋"

For any two bundles, the consumer is able to rate them in terms of desirability

> Which good he prefers

> Preference relation is an operational notion
> Choose one over the other, given the opportunity
> Consumer doesn’t know which one he prefers (there’s a model t explain this situation,
even though it is not good)

Preference relation: consumer’s ranking across all bundles according to the pleasure he/she gets
from consuming each.

> Weakly preferred: (𝑋! , 𝑋" ) ⪰ (𝑌! , 𝑌" )

o Bundle X is as good as bundle Y
o Consumer prefers X or is indifferent between the two bundles
> Indifferent: (𝑋! , 𝑋" ) ~ (𝑌! , 𝑌" )
o Bundle X is indifferent to bundle Y
o Consumer would be just as satisfied consuming the bundle X as he would be
consuming the bundle Y
> Strictly preferred: (𝑋! , 𝑋" ) ≻ (𝑌! , 𝑌" )
o Bundle X is strictly preferred to bundle Y (consumer strictly wants the X-bundle
rather than Y-bundle)

Assumptions

> Completeness: given two bundles X and Y

o Consumers can always rank them (they can always decide which bundle they like
better)
> Transitivity: for any bundles X, Y and Z
o If (𝑋! , 𝑋" ) ⪰ (𝑌! , 𝑌" ) and (𝑌! , 𝑌" ) ⪰ (𝑍! , 𝑍" ) then (𝑋! , 𝑋" ) ⪰ (𝑍! , 𝑍" ), keeping
everything else constant
> Reflexivity: (𝑋! , 𝑋" ) ⪰ (𝑋! , 𝑋" )
o Any bundle is at least as good as itself

NOTE: a consumer is rational if the preference relation is complete and transitive.

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Well-behaved preferences

> Complete
> Transitive
> Strongly monotonic: “more is always better than less”
o Preference relation is monotonic
o More is always better than less: if X is a bundle and Y is a bundle with at least as
much of both goods and more of one, then Y ≻ X
o Indifference curves have negative slope:
• If we go up and right, we would be in a better position
• If we move down and left, we would be in a worse position
• To go to an indifferent position: left and up or right and down
o Preferences of perfect complements are not monotonic
> Strictly convex: any linear combination of two bundles is strictly preferred to both
o Averages are preferred to any of the extremes
• Exception: perfect complements and perfect substitutes
o The set of bundles weakly preferred is a convex set (take any two points in a set
and draw a line segment connecting those two points, that line segment lies
entirely in the set)

Indifference curves: traces out the set of all bundles that a consumer views as being equally
desirable (indifferent).

> Doesn’t say which bundle is better than other

> If preferences are monotonic, the consumer will never be under the curve

Properties:

> Due to completeness, there is an indifference curve over any point on the good’s space
> Due to transitivity, two difference curves cannot cross each other
> Due to monotonicity:
o Bundles of goods on indifference curves further from the origin are preferred to
those on indifference curves closer to the origin
o Indifference curves slope downward (if they are indifferent to each other, one
bundle cannot have more of the two goods than other)
o Indifference curves cannot be thick (one with more of the two goods would be
indifferent to one with less)
> Due to (strict) convexity, indifference curves are (strictly) convex

Impossible indifferent curves

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Preference maps

> Graph 1: preferences over two goods: building the indifference curve through point e,
i.e., the set of all bundles that are equally desirable to e
> Graph 2: Indifference curves: the set of all bundles of goods that a consumer views as
being equally desirable (e is equally desirable to c)
Graph 1 Graph 2

Convexity: mixtures of bundles are (at least weakly) preferred to bundles themselves.

NOTE: Z is a 50-50 mixture of the bundles X and Y: Z = 0.5X + 0.5Y (included in the line)

> Preferences are strictly convex when all the mixtures Z are strictly preffered to X and Y
> Preferences are weakly convex if at least one mixture Z is equally preffered to X and Y
and the set of weakly preferred bundles to Z is a weakly convex set
> Mixtures of bundles are better than any extreme position
o Bundle Z is the average of bunfles X and Y
> Non-convexity
o The misture Z is less preferred than X and Y
o We like two goods but we don’t like them together
o The consumer would prefer to specialise, at least to some degree and consume
only one of the goods

Marginal rate of substitution (MRS): maximum amount of one good that a consumer is willing to
sacrifice to obtain one more unit of the other good on a given indifference curve.

> At some point in the IC: how many units of good 2 he would sacrifice in order to have one
more unit of good 1
> Rate at which the consumer is willing to substitute one good for the other
> Absolute value of the slope of an IC at a particular point: MRS = - (dx2/dx1)
o Slope of the line tangent to the curve in a particular point
> When good 2 is ‘income to be spent in all other goods’, MRS measures Marginal
Willingness to Pay for good 1
o Doesn’t depend on prices, only on preferences

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Convexity and MRS: convexity implys decreasing MRS

> Increasing the quantity, makes the value of that goods decrease
o We value the goods more the less we have
of them
o Diminishing MRS
o When we have more 𝑋! , the MRS will be
lower (in order to maintain the same utility
level, we need to have more of 𝑋" to
compensate)

Particular preferences

> Perfect substitutes: the consumer is willing to switch goods at a constant rate
o MRS is constant (simplest case MRS = 1)
o The slope is always the same: doesn’t depend on the
quantity of each good
o The only thing consumers care about is the total quantity
• Bundles with more total goods are preferred to
bundles with fewer total goods (increasing
preferences: up and right)

> Perfect complements: the consumer combines goods in fixed proportions (always)
o Increasing the quantity of only one of them doesn’t make any difference
o Increasing both increases the satisfaction (up and right)
o It is not monotonic (more of one good on the
same indifference curve)
o Weakly convex: whenever we take two points
won’t lead to lower utility level (not worse off but
not necessarily better off)

> Neutrals: the consumer doesn’t care about the amount of the good
o Only cares about the other good in the graphic
o MRS = 0 or infinity
o Example:
• This consumer is indifferent to lettuce
• His happiness doesn’t increase/decrease
by consuming more or less of that good
• If he hated tuna: monotonicity wouldn’t
apply and it would be like the good was a
bad thing, so we couldn’t apply the rule

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

> Economic bad: commodity that the consumer doesn’t like

o It means we are better with mess of this good
o MRS is negative
o When we have more of one good we don’t
like, we need more of the other good to
compensate the loss of welfare
o Increasing preference: right and down
(increase the amount of the commodity he
likes and decrease the amount of the
commodity he dislikes)

> Satiation: a bundle strictly preferred to any other is a satiation point or a bliss point
o Bliss point: mathematical term that applies in general
o One bundle is overall best for the consumer (the closer he is to that best bundle,
the better off he is in terms of his own preferences)
o Points on the positive slopes: you will never consume that point
• You pay more without increasing your welfare
• Too much or too little of one of the goods
• When he has too much of one of the
goods it becomes a bad (reducing the
consumption of each moves him closer
to the bliss point)
o Points with negative slopes: where the consumer
has too little or too much of both goods

> Discrete good: a commodity is discrete if it comes in unit lumps of 1, 2, 3 and so on

o Sometimes we want to examine preferences over
goods that naturally come in discrete units
o Goods are available only in discrete quantities
o Indifferent curves are collections of discrete points
o MRS is not defined
o Example: aircraft, refrigerators, televisions, etc.

UTILITY

Utility function: any mathematical function that associates a number to any possible bundle such
that: U(𝑥! , 𝑥" ) > U(𝑦! , 𝑦" ) => (𝑥! , 𝑥" ) ≻ (𝑦! , 𝑦" ) => X ≻ Y

> An IC is the set of all bundles that give the consumer a constant level of utility
> The values of the utility function have no meaning
> The only relevant property is how it orders the bundles
> Utility is an ordinal measure rather than a cardinal one

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

o It tells us the relative ranking of two bundles but not how much more one bundle
is valued than another
o We don’t care what are the values of U(X) and U(Y), we care that X ≻ Y or vice-
versa
o Any utility function that generates X ≻ Y would be consistent with these
preferences

Monotonic transformation: way of transforming one set of numbers into another set of numbers
on a way that preserves the order of the numbers

> Utility function that represents the same preferences as the original utility function
> U(𝑥! , 𝑥" ) > U(𝑦! , 𝑦" ) ó F[U(𝑥! , 𝑥" )] > F[U(𝑦! , 𝑦" )]
> If F[U(X)] is a positive monotonic transformation of U(X), then both utility functions
represent the same preferences
> Graph of monotonic function: positive slope

Marginal utility: how the consumer’s utility changes if consumption of a good increases by one
unit, keeping the other constant: MU! = 𝜕U/𝜕𝑥! and MU" = 𝜕U/𝜕𝑥"

• MRS: 𝜕U = 0 = (𝜕U/𝜕𝑥! ) x 𝜕𝑥! + (𝜕U/𝜕𝑥" ) x 𝜕𝑥" => MRS = - 𝜕𝑥" / 𝜕𝑥! = MU! / MU"
• A positive monotonic transformation of a utility function U, changes the values of
Marginal Utility (no real meaning) but not the values of MRS (real meaning)
> Example: U = 3𝑥! 𝑥" => MU! = 3𝑥" and MU" = 3𝑥!
V = 2U => MU! = 6𝑥" and MU" = 6𝑥!
For U and V: MRS = 𝑥" /𝑥! is the same

Particular Utility functions

> (a) Perfect substitutes: consumers substitute one good by the other at a constant rate
o U(𝑥! , 𝑥" ) = i𝑥! + j𝑥"
o Slope = - i/j
o The consumer is indifferent between j quantities 𝑥" of and i quantities of 𝑥!

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

> (b) Perfect complements: this consumer always combines i𝑥! with j𝑥"
o MRS is undefined
o U(𝑥! , 𝑥" ) = min {i𝑥! , j𝑥" }

> (c) Imperfect substitutes: strictly convex indifference curves

o Cobb-Douglas utility function
• Simplest representation of well-behaved IC
• IC never hit the axes
• U(𝑥! , 𝑥" ) = 𝑥!∝ 𝑥"!$∝
o Quasilinear utility function
• IC hit one of the axes
• U(𝑥! , 𝑥" ) = 𝑢𝑥! + 𝑥"
• MRS depends only on 𝑥!
• If we fix 𝑥! , we’ll get the same MRS
• IC have the same slope on the vertical line

Homothetic preferences: the whole indifference map can be derived from a single indifference
curve

> The MRS only depends on the proportion of consumption of each good
o Not on the absolute quantity of goods
o When that proportion is fixed, we get the same MRS
o For the same proportion (along any line from the origin)
the slope of any IC is the same
> Includes perfect substitutes, perfect complements and Cobb-Douglas preferences

BUDGET CONSTRAINT

Economic possibilities faced by a consumer.

Each consumer chooses the best set of goods he can afford

> Consumer is the evaluator of his welfare

> Budget set: set of affordable consumption bundles at prices (𝑝! , 𝑝" ) and income (I)

Assumptions

> The choice is between two goods (1 and 2)

> The good prices, 𝑝! and 𝑝" , and the consumer revenue, I, are given (exogenous)

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

o (0,8) and (24,0) are corner solutions

o All the points on or below the line are affordable
o The expenditure of good 1 and 2 cannot go over budget
o All the variables are flow variables
• 𝑝! 𝑥! + 𝑝" 𝑥" = I (budget line = set of bundles that
cost exactly I)
%
• 𝑥" = I/𝑝" – (%! ) 𝑥!
"
> Negative slope: variations on good 1 and 2 must be always in opposite directions
o The slope (absolute value) measures the market exchange rate between goods
%!
o – is the opportunity cost of good 1 (𝑥! ) measured in units of good 2 (𝑥! )
%"

The Numéraire: the price of one good is equal to 1.

> The numéraire price is the relative price to which we are measuring all prices and incomes
> We are defining the good relative to the numéraire price
> The budget line is defined by two prices, 𝑝! and 𝑝" , and a given level of income, I. But
one of these variables is redundant:
%!
o 𝑝! 𝑥! + 𝑝" 𝑥" = I ó I/𝑝" = ( ) 𝑥! + 𝑥"
%"
> Example: 𝑝" is equal to 1 and the vertical axis measures
consumer’s income left to consume in other goods

Comparative Statics: alternative is a dynamic analysis.

> When prices and income change, the set of goods a consumer can afford changes as well

1. Income increases

> Increase the vertical intercept

> The budget constraint shift upwards
> The new line is parallel to the original one
o Doesn’t affect the slope

2. 𝑝! decreases

> The slope decreases

o Becomes flatter
> With a lower price, the consumer can buy
more of this good
> Doesn’t change vertical interception

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

3. 𝑝" decreases
> Steeper line
o Linha mais íngreme

4. The same percentage change in 𝑝! and 𝑝"

> Parallel shift in the budget constraint

> Similar changes in both prices
> Same effect as a change in income
> In this example: increase in the VAT rate

5. Prices and Income change proportionally

> The budget line is the same

> Example: Inflation

Particular cases

> Budget constraint with rationing

o Usually the consumer is always on the budget constraint
o He might want to save
o We are assuming he has decided before how much to spend and to save
o If indivisibility is an issue, we can’t connect the dots
o In this example: you cannot go to the cinema more than 6 times

> Prices increasing with quantity

o used to induce consumption savings

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

o Example: a telecom operator charges

15€/month for 30 minutes’ calls. Above it
calls are charged 0,2€/minute and I = 120€

> Prices increasing with quantity

o Same example as above
o Greatest aim of the company: increase and promote consumption

CONSUMER CHOICE

The consumer chooses the best set of goods he can afford.

For well-behaved preferences, the optimal choice is the bundle on the budget line tangent to the
highest indifference curve.

> e is the optimal choice

> c is affordable but not preferred
> f is not affordable
> We want to find the bundle in the budget set that is
on the highest indifference curve
o Only bundles that lie on the budget line
(more is better than less)

Consumer’s demanded bundle: optimal choice of good 1 and 2 at some set of prices and income.

> When 𝑞!∗ > 0 and 𝑞"∗ > 0, the demanded bundle is interior.
o Strictly positive quantities of both goods (opposite of corner solutions)

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

> If buying (𝑞!∗ , 𝑞"∗ ) costs Y then the budget is exhausted

o The optimal set exhausts the budget
'( %
%"
o Slope = ' = - %!
(%! "

o Max U(𝑞! , 𝑞" )

𝑞# , 𝑞$ subject to (s.t.): I = 𝑝! 𝑞! + 𝑝" 𝑞"
o Find the highest utility function, but that is affordable
o Can transform into a problem without the constraint:
' % ' %
• 𝑞" = % - %! 𝑞! => U(𝑞! , % - %! 𝑞! )
" " " "
o He chooses the furthest point but still on the budget line
> The optimum is stated as in the graphical analysis, also called Tangency Condition:
) %
o MRS = - )! = - %! = MRT (marginal rate of transformation)
" "
o Point where the slope of the budget constraint is equal to the slope of the IC
%
MRS = %!
"

I = 𝑝! 𝑞! + 𝑝" 𝑞"

o Langragean function: ℒ = U +𝜆(𝑝! 𝑞! + 𝑝" 𝑞" )

*ℒ
*,!
=0
%
MRS = %!
*ℒ "
*,"
=0ó
I = 𝑝! 𝑞! + 𝑝" 𝑞"
*ℒ
=0
*-
.) % .)! .)"
o The tangency condition can be rewritten as: .)! = %! ó %!
= %"
" "
• In equilibrium, the marginal utility of the last euro spent in each
o Is it a necessary condition for the optimum?
• It’s not a necessary condition (interior
solution in perfect complements)
• It’s not necessary in corner solutions

• It’s not a sufficient condition for a maximum (Interior solutions: non-

convex or not strictly convex preferences)

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

> If IC are non-convex and the optimal choice is an interior solution, the tangency condition
is necessary but not sufficient
> If IC are convex, the tangency condition is sufficient but not necessary for an interior
solution
> If IC are strictly convex, the tangency condition is necessary and sufficient for an interior
solution and the optimal choice is unique

In well-organized markets, all active consumers will have the same

marginal willingness to pay for that good. Observing one market
choice provides information about consumers Eventhough the
consumers have different IC they have the same ratio of Mus for the
two goods.

Utility maximization has a dual problem: expenditure minimization in which the consumer seeks
the combination of goods that achieves a certain level of utility for the least expenditure.

Minimize expenditure, E, subject to the constraint of holding utility constant:

> min E = 𝑝! 𝑞! + 𝑝" 𝑞"

𝑞# , 𝑞$ s.t.: U = U(𝑞! , 𝑞" )

The solution to this problem, the expenditure function, gives the

minimum expenditure necessary to achieve a specified level of
utility for a given set of prices: E = E(𝑝! , 𝑝" , U)

CHANGING INCOME AND PRICES

Changing prices and optimal choice (𝑞!∗ , 𝑞"∗ )

> Price consumption curve and demand curves 𝑞! (𝑝! , 𝑝" , I) and 𝑞" (𝑝! , 𝑝" , I)
> Ordinary good and Giffen good
> Price elasticity
> Cross-price effects

Changing income and optimal choice (𝑞!∗ , 𝑞"∗ )

> Income consumption curve and Engel curve

> Normal good (luxury and necessity goods) and inferior goods
> Income elasticity

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Effects of a change in Income: how a change in income affects a consumer’s utility maximizing
consumption decisions (income effect).

> To isolate this effect, we hold everything else constant: prices and preferences
> The impact of a change in income (while keeping prices constant) on utility maximizing
choices can be examined in three different ways
o Income-consumption curve
o Engel curve
o Shifts in demand curve

Income-consumption curve: using the consumer’s utility

maximization diagram, connects optimal consumption
bundles for different income levels, keeping the prices of the
two goods constants (the locus of all optimal consumption
bundles when income changes and prices are constant in
(𝑞! , 𝑞" ) plane).

Engel curve: shows the relationship between income and

optimal quantity demanded of a given good keeping prices
constant.

Shifts in demand curve: using demand diagram, we show how the quantity demanded changes
when income changes for the same price level.

Effects of an increase in income on:

*,%
> Normal goods: both good 1 and good 2 are normal goods: *'
>0

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

*,!
> Inferior goods: good 2 is normal and good 1 is inferior: <0
*'

Income elasticities (of demand): percentage change in the quantity demanded of good 1, 𝑞! ,
when income I changes by 1% (holding prices constant).

> Formally:

> Normal goods: those goods that

we buy more of when our income increases, have a positive income elasticity:
o Luxury goods: normal goods with an income elasticity greater than 1 (share of
those goods increase with income): beach homes, jewellery, first-class tickets
o Necessity goods: normal goods with an income elasticity between 0 and 1 (share
of those goods in consumer’s budget falls as income grows): toothpaste, salt
> Inferior goods: those goods that we buy less of when our income increases, have a
negative income elasticity: perceived by consumers as low quality goods

The shape of the income-consumption curve (ICC) for two goods tell us the sign of their income
elasticities.

Particular cases

> ICC for Cobb-Douglas preferences

.)! ∝ ," %!
o MRS = = x = > Engel Curve for Cobb-Douglas preferences
.)" !$∝ ,! %"
%! ,! % ,
% !$∝ o I= ó∝= ! !
∝ '
o ICC: 𝑞" = %! x ∝
x 𝑞!
"

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

o The Engel curve for homothetic

preferences is linear

> ICC for perfect substitutes > Engel Curve for perfect substitutes

> ICC for perfect complements > Engel Curve for perfect complements

Changing Income and shifts in demand curve

*,!
> Income increases and good 1 is normal: *'
>0

o When the income increases, the

quantity demanded of good 1 also
increases

> Income increase and good 1 is inferior:

*,!
<0
*'

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

o When the income increases, the

quantity demanded of good 1
decreases

SUBSTITUTION AND INCOME EFFECTS

The impact of changing 𝑝! in the quantity demanded of good 1, 𝑞! , given 𝑝" and I, can be seen
as the result of two effects:

> Substitution effect: when the price of one good changes relative to the price of the other
good, consumers buy more of the good that has become relatively cheaper and less of
the good that is now more expensive: pure price effect
o This effect is always non-positive
> Income effect: a price shift changes the purchasing power of consumers’ income, i.e., the
amount they can buy with a given amount of euros. In particular, it increases when price
decreases and vice-versa
o This effect an be positive or negative

Total effect of a price change

> A: the optimal choice before the price change

> F: the optimal choice after the price change

If 𝑝! increases, the quantity demanded of good 1, 𝑞! , given 𝑝" and I, decreases. This effect is
measured in the demand curve of good 1 and is the total effect of that price change (previous
slide). However, it can be decomposed into:

> Substitution effect: pure price effect that results from the increase in the price of the
good making it less attractive relative to others, implying that less of good 1 will be
chosen
> Income effect: as the price increases by income effect the consumer is “poorer”. Then, if
the good is normal, less o the good will be consumed, while of the good is inferior, more
o the good will me consumed

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Conclusions

> The direction of the substitution effect is unambiguous

o When price increases, individuals consume less of the good because they are
substituting away from the now more expensive good
> The direction of the income effect depends upon whether the good is normal or inferior:
o When price increases and the good is normal, the income effect is negative
o When price increases and the good is inferior, the income effect is positive

Isolating the substitution effect from the income effect

To isolate the substitution effect from the price effect following

the increase in the price of good 1, we can compensate the
consumer for the price increase (recall the consumer is “poorer”)
so that:

> The consumer’s initial utility level is kept (initial IC) after the price change: substitution
effect à la Hicks, or, in alternative,
> The initial bundle remains affordable to the consumer at new prices: substitution effect
à la Slutsky

SUBSTITUTION EFFECT À LA HICKS

How does the demand of good 1 change when its price changes and the consumer keeps the
initial utility level (stays at the initial IC)?

To disentangle substitution effect from income effect:

> Suppose the consumer is compensated with extra income to keep the initial utility level
(before price has changed)
o Substitution effect: from 𝑄/ to 𝑄0
o It is always non-positive due to decreasing MRS (e-mail)
o ∆𝑃! > 0 => H must always be to the left of A

Income effect à la Hicks

How does the quantity demanded of good 1 change due to the change in income?

> Graphically: from 𝑄0 to 𝑄1

Normal good: the income effect reinforces the substitution effect

> Substitution effect: from 𝑄/ to 𝑄0 < 0

> Income effect: from 𝑄0 to 𝑄1 < 0
> Total effect: from 𝑄/ to 𝑄1 < 0

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Inferior good: the income effect is opposite to the substitution effect

> Substitution effect: from A to H < 0

> Income effect: from H to F > 0
> Total effect: from A to F < 0

Giffen good: the good is inferior and the income effect is opposite and in absolute value greater
than the substitution effect

> Substitution effect: from 𝑄/ to 𝑄0 < 0

> Income effect: from 𝑄0 to 𝑄1 > 0
> Total effect: from 𝑄/ to 𝑄1 > 0 (positive: price and
quantity change in the same direction)

Giffen good

For poor consumers, when the price of the good that is the basis
of their daily diet increases, which also represents the largest
shape of their income, their loss is so large that they must
increase the amount purchased of that good for survival and
reduce the amour of some other good they were purchasing
before, such as meat (ex. Potatoes in Irish famine in mid-1800’s)

Though, there was some controversy about the existence of

Giffen behaviour.

How to compute Substitution and Income effects

Substitution effect from A (𝑝!2 , 𝑝"2 , 𝐼 2 ) to H (𝑝!! , 𝑝"2 , 𝐼! )

> Alternative 1
o 𝑈 0 (𝑞!! , 𝑞"! ) = 𝑈2 = 𝑈 / (𝑞!2 , 𝑞"2 )
0 𝑝!
o 𝑀𝑅𝑆!," = != 2
𝑝"
! ! 2 !
o 𝑝! 𝑞! + 𝑝" 𝑞" = 𝐼!
Where:
o (𝑝!! , 𝑝"2 ) represents the price vector at H (new prices, same as in F)
o 𝐼! is the compensated income

Solving the system of three equations above we obtain (𝑞!0 , 𝑞"0 ) = (𝑞!! , 𝑞"! ) and 𝐼!

So, (𝐼! - 𝐼 2 ) is the compensation or the extra income the consumer must receive to keep
the same utility level, 𝑈2 , at the new prices.

> Alternative 2
In alternative to solving the system of equations we may use the indirect utility function,
V (𝑝! , 𝑝" , 𝐼), which is obtained by substituting the demand functions of good 1 and good
2 into the utility function U(.) and gives the level of utility for 𝑝! , 𝑝" , 𝐼 as follows:
o U (𝑞! (𝑝! , 𝑝" , 𝐼), 𝑞" (𝑝! , 𝑝" , 𝐼)) = V (𝑝! , 𝑝" , 𝐼)

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Since 𝑈 0 (𝑞!! , 𝑞"! ) = 𝑈2 = 𝑈 / (𝑞!2 , 𝑞"2 ), we have that:

o V (𝑝!2 , 𝑝"2 , 𝐼 2 ) = 𝑈2 = V (𝑝!! , 𝑝"2 , 𝐼! )

Hence, 𝐼! can be obtained from this last equality. Using now the tangency condition and
the budget condition at H, H can be obtained.

> In summary
H can be obtained by solving the following system of equations:
o V (𝑝!! , 𝑝"2 , 𝐼! ) = 𝑈2
0 𝑝!
o 𝑀𝑅𝑆!," = != 2
𝑝"
! ! 2 !
o 𝑝! 𝑞! + 𝑝" 𝑞" = 𝐼!
Where the compensated income is obtained by solving the first equation, and from the
other two the optimal quantities for good 1 and 2 are obtained.

Income effect from H (𝑝!! , 𝑝"2 , 𝐼! ) to F (𝑝!! , 𝑝"2 , 𝐼 2 )

SUBSTITUTION EFFECT À LA SLUTSKY

How does the demand of good 1 change when its price changes and the initial bundle remains
affordable to the consumer at the new prices?

> Suppose the consumer receives an extra income such

that the initial bundle is still affordable at new prices

How to compute Substitution and Income effects

Substitution effect from A (𝑝!2 , 𝑝"2 , 𝐼 2 ) to S (𝑝!! , 𝑝"2 , 𝐼!4 )

5 𝑝!!
> 𝑀𝑅𝑆!," = =2
𝑝"
> 𝑝! 𝑞! + 𝑝" 𝑞" = 𝐼!4 = 𝑝!! 𝑞!2 + 𝑝"2 𝑞"2
! ! 2 !

Where:

> (𝑝!! , 𝑝"2 ) represents the new price vector (the same as in F)
> 𝐼!4 is the compensated income à la Slutsky

Solving the second equation above we obtain 𝐼!4

Then, S = (𝑞!! , 𝑞"! ) can be obtained solving the two equations

So, (𝐼!4 - 𝐼 2 ) is the compensation or the extra income the consumer must receive to afford the
initial bundle A at the new prices, and is different from à la Hicks.

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

COMPARISON BETWEEN SUBSTITUTION EFFECTS

Comparing Hicks and Slutsky substitution effects:

> Slutsky compensation > Hicks compensation

Particular cases

> Perfect complements

o Substitution effect = 0
o Only income effect

> Perfect substitutes

o Example 1
• Only substitution effect
• Income effect = 0
• Substitution effect à la Hicks =
Substitution effect à la Slutsky

o Example 2
• Substitution effect = 0
• Income effect is total effect
• Total effect à la Hicks = Total
effect à la Slutsky

> Quasi-linear preferences

o Choice between all other goods (composite good) and some single good which
does not represent a large part of consumer’s budget (small income effects), at
least when income is large enough
o U = 𝑞" + 𝑓(𝑞! )
*6
o
*,!
>0
*" 6
o
*,! "
<0
o IC: 𝑞" = U - 𝑓(𝑞! )
o Linear in good 2 and non-linear in good 1
(strictly concave)
.)! *6
o 𝑀𝑅𝑆!," = =
.)" *,!
o 𝑀𝑈" = 1
o MRS only depends on 𝑞! , implying that ICs are parallel to each other on the
vertical

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Summarizing

> Demand of good 1 does not depend on income, only the demand of good 2 depends on
income: all income changes only impact the demand of good 2
> The demand of good 2 does not depend on the price of good 1: so if 𝑝" increases the
demand of good 1 increases, but 𝑝! increases the demand of good 2 is not affected: so
good 1 is a substitute for good 2 but good 2 is independent from good 1
> So, (gross) complementary and substitutability are not symmetric between goods

Quasi-linear preferences:

> Substitution effect on both goods

> Income effect = 0 on good 1 (F is in the vertical line of
H: same MRS)
> Income effect is negative on good 2

MEASURE WELFARE IMPACT OF PRICE CHANGES

Measuring welfare changes based on compensation à la Hicks (à la Slutsky)

> By how much the consumer needs to be compensated or willing to accept so that she/he
after the price increase is well-off as before the price change? Compensating Variation:
CV (if price decreases is willing to pay because is better off)
> In alternative, what is the change in income that is equivalent in terms of welfare to the
price increase? So, how much is the consumer willing to pay to avoid the price increase?
Equivalent Variation: EV (willing to accept for price decrease)

Variation à la Hicks

Hypothesis: ∆𝑝! > 0

> CV: the extra money we would have to give

the consumer to “compensate” her for the
price increase (would keep the initial utility,
that is, the original IC, with the final prices)

> EV: the amount of money that would be

“equivalent” in terms of (loss of) welfare to
the price increase for the consumer (would
keep the final utility, that is, the final IC, with
the initial prices)

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

> Comparing CV and EV

o If ∆𝑝! > 0 and good 1 is normal, then CV ≥ EV

o Which should be chosen?

• Welfare impacts of a subsidy (EV): how does the consumer value de
decrease in price? (willingness to accept for the price decrease)
• Welfare impacts on inflation in pensioners (CV): how can pensioners be
compensated for the price increase? (willingness to accept the price
increase)

Comparing Hicks and Slutsky variation

• CV for a price increase: Slutsky CV • EV for a price increase

over-compensates because it ignores
the substitution effect

MARKET DEMAND

Demand function: describes the mathematical relationship between quantity demanded in the
market (Q) for a given good, its price (p) and the factors that influence purchases:

Q = D(p, pS, pC, Y)

• p = per unit price of the good or service

• pS = per unit price of the substitute good
• pC = per unit price of a complementary good
• Y = consumer’ income

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Market demand: result of the horizontal sum of every individual’s demand function. For each
price level, we add up the quantities purchased by each consumer.

• Changing p simply moves us along the entire demand curve

• Changing one of the things held constant (p, pS, pC) shifts the entire demand curve

Price Elasticity of Demand: measures how sensitive the quantity demanded of a good, Q, is to
changes in the price of that good, p.

ε = (% change in Q)/(% change in p) = (∆Q/Q)/(∆P/P)

Q = a – bp (linear demand)

• ε = - (𝜕Q/𝜕p) x (p/Q) = - (-b) x p/Q (in absolute value) and elasticity can be evaluated at
any point on the demand function
• A 1% increase in the price of pork leads to a ε% decrease in the quantity of pork
demanded
• Long-run price elasticities are usually larger than short-run

Price Elasticity of Demand

Elasticity of demand varies along a linear demand curve.

Elasticity and firms’ revenue (or consumer expenditure)

• To increase revenues, Metro increases prices

• At the same time, to increase revenues, cinemas UCI drop prices
• Is any of these decisions wrong?
> If demand is inelastic, increases in prices increases revenues
> If demand is elastic, increasing prices decreases revenues

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Price Elasticity of Demand and Revenues

Particular Cases

Perfectly elastic Demand: at p=p’ consumers will buy as much as the firm sells.

Perfectly inelastic Demand: demand for broadband services by large firms.

Other Elasticities

Income elasticity of demand (keeping prices constant)

• ε = (% change in Q)/(% change in Y) = (∆Q/Q)/(∆Y/Y) = (𝜕Q/𝜕Y) x (Y/Q)

Cross-price elasticity of demand (keeping all other prices and income constant)

• ε = (% change in Q)/(% change in price of another good) = (∆Q/Q)/(∆p0/p0)

ε = (𝜕Q/𝜕p0) x (p0/Q)

PRODUCER BEHAVIOR

A firm is an organization that uses inputs (labour, materials and capital) to produce outputs.

Firm types

• Private (for-profit) firms

• Public firms
• Non-profit firms

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Assumption: firm’s owners are driven to maximize profit

Profit (π)= R – C (what is earned – what is spent paying labour, materials, taxes, etc.)

• To maximize profit, a firm must produce as efficiently as possible, where efficiency in

production means it cannot produce its current level of output with fewer inputs.

PRODUCTION FUNCTION

q = f (L, K)

A firm can more easily adjust its inputs in the long run than in the short run.

• The short run is the period of time during which at least one factor of production cannot
be changed (the fixed costs)
• The long run is a long enough period of time necessary for all inputs to be fully adjustable

Short run Production Function or Total Product of Labour

In the SR, we assume that capital is a fixed input and labour is a variable input, so installed capacity
is fixed.

• q = f (L, K(fixed))
• q = output = total product (TP)

The marginal cost of labour Is the additional output produced by an additional unit of labour,
holding all other factors constant:

• MPL = 𝜕q/𝜕L = 𝜕f (L, K(fixed))/ 𝜕L

The average product of labour is the ratio of output to the amount of labour employed:

• APL = q/L = f (L, K (fixed))/L

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Law of Diminishing Marginal Returns (LDMR)

LDMR: when a firm keeps increasing an input, holding all other inputs and technology constant,
the corresponding increases in output will eventually become smaller (L=10 in previous graph).

Formally 𝜕MPL/𝜕L = 𝜕(𝜕q/ 𝜕L)/ 𝜕L = 𝜕2 f (L, K(fixed))/𝜕L2 < 0

• When MPL begins to fall, TP is still increasing

• LDMR is an empirical regularity more than a law

LONG RUN

Technologies with Multiple Variable Inputs

• In the LR, we assume that both labor and capital are variable inputs.
• The freedom to vary both inputs provides firms with many choices of how to produce
(labour-intensive vs. capital-intensive) methods)
• When K is fixed, the diminishing marginal product limits a firm’s ability to produce
additional output by using more and more labour. Hiring another worker only helps if
more capital can be used: more K and L at the same time allows the firm to avoid at least
in part the effects of diminishing marginal products

Isoquants

A production isoquant graphically summarizes all possible efficient combinations of inputs (labour
and capital) to produce a given level of output: counterpart of indifference curves. However,
production is a cardinal concept!

Properties

• The further an isoquant is from the origin, the

greater the level of output
• Isoquants do not cross
• Isoquants slope downward
• Isoquants must be thin

Slope: shows how the firm can replace one input for
another holding output constant.

Marginal rate of technical substitution (MRTS) is the absolute value of the slope of an isoquant at
a single point.

• MRTS = 𝜕k/𝜕L = MPL /MPK

• MRTS decreases along a convex isoquant
> More L => harder to replace K for L

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Elasticity of Substitution: measures the ease with which a firm can substitute capital for labor.

or

Constant Elasticity: 𝜎 = 1/(1 – p)

Production Function

Cobb-Douglas:

Particular Cases:

• Perfect substitutes: MPL and MPK are constant

• Perfect complements or Leontieff Technology: fixed proportions

• Types of Isoquants: strictly convex

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Professor Antonieta Cunha e Sá 2nd Year, 2nd Semester

Returns to Scale (diseconomies of scale) are only defined in the long-run, when the quantity of
any input can vary

• This contrasts with the case of marginal returns (increasing or decreasing) which measure
the change in output when one input varies and others are kept constant
• The production function exhibits constant returns to scale when a percentage increase
in inputs is followed by the same percentage increase in output
> Example: doubling inputs => doubles outputs

Question: Can technology exhibit increasing returns-to-scale even if all its marginal products are
diminishing? YES!

PRODUCTIVITY AND TECHNICAL CHANGE

Even if all firms are producing efficiently, firms may not be equally productive.

Relative productivity of a firm is the firm’s output as a percentage of the output that the most
productive firm in the industry could have produced with the same inputs. It depends on:

• Management skill/organization
• Technical innovation
• Union-mandated work rules
• Work place discrimination
• Government or other industry restrictions
• Degree of competition in the market

An advance in firm’s knowledge that allows more output to be produced with the same level of
inputs is called technical progress/technological change

• Neutral technical change: involves more output using the same ratio of inputs
• Non-neutral technical change: involves altering the proportion in which inputs are used
to produce more output (labor saving and capital saving)

Organizational change may also alter the production function and increase output.

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